COST OF CAPITAL

FM - 1
Sem 1
 Evaluating an Investment Project
 Requires two basic inputs:

The estimates of the project’s cash flows

–The

The discount rate

–The

So far we assumed the discount rate as

known!!

This chapter => Estimating the discount

rate OR the cost of capital
 What is Cost of Capital?
 The cost of capital for a project is the discount
rate for discounting its cash flows.

 It is the minimum required rate of return on

funds committed to the project, which depends
on the riskiness of the cash flow.

Since the investment projects undertaken by a

firm may differ in risk, each have its own unique
cost of capital.
Risk difference in Shareholder’s & Creditor’s Claim

 Investors will require different rates of return

on various securities since they have risk
differences.
OCC

Equity Capital

Preference Shares

Corporate Bonds

Risk free security

Risk
 Various sources of funds

 Equity Capital

 Preference Capital

 Retained Earnings

 Debentures

 Term Loans
 Cost of Equity Capital
Firm have 2 ways to raise equity capital:

–Retained earning (i.e. shareholders foregoing

dividends)
Distributing retained earning & then issuing new
–Distributing
shares

•From firm’s point of view:

External equity will cost more than internal
equity:
 Floatation costs
 Issue at lower prices
 Cost of Internal Equity Capital contd.
Existing Equity shareholders expect DIVIDENDS
as return.

Dividend Valuation Model:

n Dt
P0 = Σt=1 (1+ke)t

P0 = D1
ke - g
Hence Cost of equity is,
P0 is current price of share
D1 D1 is expected dividends
ke = + g g is growth of dividends
P0
Sum:

 If the last dividend declared is Rs 2 per

share, the growth rate in dividend is 12%
and the price per share is Rs 80, the cost
of equity capital is:
Cost of Internal Equity Capital: Other methods

Realized Yield Approach: here past returns are

taken as a proxy of future returns.

ke = (W1 * W2 * W3 * ………Wn)1/n – 1,

where, w = wealth ratio, Wt = (Dt + Pt)/ Pt–1

CAPM Approach:

ke = rf + β (Rm – rf)
 Sum

From the following table calculate the cost of equity

for the firm.

Year 1 2 3
DPS (Rs) 1.50 2.00 1.50
Price per share at end of the 12.00 11.00 12.00
year (Rs)

Also given is price per share at the beginning of

year 1 as Rs 10.
 Cost of Retained Earnings
 Same as Internal Equity, kr = ke

Cost of External Earnings

 Floatation cost are involved
D1
k’e = + g
P0 (1-f)

Approximation formula: ke
k’e = (1-f)
 Sum:

 The current market price of the shares of Tractor India

Limited is Rs 60. The company recently paid a dividend
of Rs 3 per share that is expected to grow at a rate of
8%. If the floatation cost is 2% of the current market
price, what is the cost of external equity.
 Cost of Preference Capital
 Redeemable Preference:
n Div F
P =Σ +
t=1
(1+kp)t (1+kp)n

Approximation formula:

F-P
Div + n
kp =
D = preference dividend
F+P
F = redemption price
2
P = price realized
 Cost of Debentures
n
I (1 – t) F
P = Σt = 1 +
(1+kd)t (1+kd)n

Approximation formula:

I (1 – t) + F n- P I = interest payment
kd =
F+P F = redemption price
2 P = price realized
t = corporate tax rate
When the difference between
I (1 – t) + F n- P X (1 – t)
kd = redemption value and the price
F+P realized is written off evenly
2 over the life of debentures.
 Cost of Term Loans

I = Interest Rate
kt = I (1 – t)
t = tax rate
 D1
Cost of Equity ke = + g
P0
Cost of Retained Earnings kr = ke

Cost of External Equity ke

k’e =
(1- f)
F-P
Cost of Preference Capital D + n
kp =
F+P
2
I (1 – t) + F - P
Cost of Debentures n
kd =
F+P
2
Cost of Tem Loans kt = I (I – t)
Sum:
Market Value
Equity Capital (80,000 shares of Rs 10 FV) 100,00,000
15% Preference Capital (6000 shares @ Rs 100 FV) 621,000
14% Debentures (Par value of Rs 1000) 970,000
16% Term Loan 800,000

Dividend per share expected for next year is Rs 3.50 and expected
to grow at the rate of 12%. It is presently selling at Rs 125.

Preference shares are redeemable after 5 years at premium of 5%.

Presently selling at Rs 103.50.

Debentures are redeemable after 10 years at face value.

Presently selling at Rs 970.

Applicable tax rate for the company is 40%.

Find the weighted average cost of capital for the company.